The Next Gusher

OVER LONG PERIODS, the shares of oil and gas producers tend to shadow trends in the underlying commodities, particularly crude oil.

Yet since early last year, energy stocks and oil prices have gone their separate ways. Oil prices doubled to nearly $40 a barrel on expectations of war in the Middle East and disruptions to oil supplies. But the shares of U.S. integrated oil and gas concerns fell about 15% in 2002, as investors looked ahead to a collapse in crude prices, to $20 a barrel or less, in the postwar world.

So far, the equity crowd has judged the situation well. Crude prices plummeted 30%, to $27 a barrel, last week, as U.S. troops met little resistance in their initial assault on Iraq. But don't get too comfortable with the notion that further development of Iraq's massive oil reserves, thought to total 112 billion barrels, will depress prices permanently, says Tom Petrie, chief executive of Petrie Parkman, a Denver-based investment bank specializing in energy. "It will be clear within a year that Iraqi oil won't be a panacea for the world," says Petrie, a veteran observer of oil's oscillations.

To those who think Iraq will be able to double its oil output soon, Petrie warns the process will take longer, and cost far more, than anyone now expects. Eventually, he wagers, this rosy scenario will be viewed just as skeptically as the productivity miracle and the New Economy, popular myths that animated the bubble market of the late 1990s.

Petrie expects oil prices to average $25 to $30 a barrel this year, with the high end of that range more likely. The war will disrupt oil fields and supply lines in the Middle East, he notes, even as the giant fields in Alaska and the North Sea mature. Moreover, global inventories of crude and refined products are low, while demand worldwide is growing.

Natural-gas prices, which tend to fluctuate with crude, also are likely to exceed current market expectations of $3 to $3.50 per million British thermal units. Petrie sees gas prices of $3.50 to $4.50 per MMBtu, rising to $4-$7 over the coming decade.

Petrie's predictions aren't good news for consumers, who already have seen gasoline prices soar. But oil refiners are likely to be quietly rejoicing, because a drop in pump prices will lag behind the fall in crude. Petrie expects gasoline and diesel-fuel refiners to enjoy "a couple of quarters of good operating margins," on the order of $6.50 a barrel, up from an average of $5.45 last year. This could translate into about a 20% increase in industry operating profits for the year, which in turn could propel the stocks by 25% to 40%.

Gasoline fundamentals, in general, are stacking up in the refiners' favor; U.S. gasoline inventories are approaching an eight-year low, while demand is nearing an eight-year high. That's because summer vacation in the U.S. is apt to mean a road trip in this year of global unrest, and what's on the road -- a fleet of giant sport-utility vehicles -- is guzzling more gas than ever.

And this prediction doesn't even take into account the possibility that the U.S. economy will perk up this summer, adding to energy demand.

Refining stocks, on average, are trading for seven times Petrie Parkman's 2003 estimated earnings -- "too low for the kind of margins our analysts are expecting," Petrie says. The firm has "Buy" ratings on
Premcor,Valero Energy
and
Tesoro Petroleum.

Although Premcor has been public only since last April, the company has "high-quality, focused refining assets" exposed to Midwest and Gulf Coast markets, and an experienced management team, Petrie says. The stock is trading for about 25, or just over eight times this year's expected earnings.

Valero, with $27 billion in 2002 revenue, is the "gold standard" among refiners, with a greater product-refining capacity and market capitalization -- some $4.46 billion -- than any other independent refiner. Tesoro, on the other hand, presents perhaps the biggest risk/reward opportunity. The company's debt now equals 69% of total capitalization, one of the highest debt-to-capital ratios in the sector, while its price/earnings multiple is one of the lowest. If Tesoro shores up its finances, as planned, the company's exposure to the big California market could yield handsome returns.

Petrie's similarly favorable view of independent exploration and production stocks was neatly underscored last week by the Senate's rejection of oil drilling in an Alaskan wildlife refuge. By summer, with the war in Iraq presumably over, the government's focus will rotate again to improving U.S. energy supplies. And that means natural gas.

Even with relatively high gas prices -- currently $5.15 per MMBtu -- drilling for new gas hasn't yielded great results. Either exploration and production companies don't believe these prices will hold, or they are running out of good properties to drill, Petrie says. "I think it's the latter," he adds.

Over the past 12 months, as crude prices surged, the shares of U.S. E&P concerns drooped 12%, while refiners' shares fell nearly twice as much. Ironically, energy stocks increasingly will be viewed as "investable" as crude prices come down, because lower oil prices will be considered more sustainable, Petrie says. Last year it paid to buy the commodity and sell the shares. But if Petrie's right, the gusher this year will be on Wall Street, not in the oil patch.

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